Suggested Answer Syl16 June2019 Paper 14 FINAL EXAMINATION · (iii) The spot Value of Nifty is 4430. An investor bought a one month Nifty 4410 call option for a premium of ` 12. The

Suggested Answer_Syl16_June2019_Paper_14

Academics Department, The Institute of Cost Accountants of India (Statutory Body under an Act of Parliament) Page 1

FINAL EXAMINATION

GROUP III

(SYLLABUS 2016)

SUGGESTED ANSWERS TO QUESTIONS

JUNE 2019

Paper- 14: STRATEGIC FINANCIAL MANAGEMENT

Time Allowed: 3 Hours Full Marks : 100

The figures in the margin on the right side indicate full marks.

Working Notes should form part of the respective answers.

Wherever necessary, candidates may make appropriate assumptions and clearly state them.

No present value factor table or other statistical table will be given in addition to this question

paper. Candidates may use the values tabulated at the end of this question paper.

This paper contains two sections, A and B. Section A is compulsory and contains question no. 1

for 20 marks. Section B contains question numbers 2 to 8, each carrying 16 marks.

Answer any five questions from Section B.

Section – A

Answer all the questions. Each question carries two marks.

1. (a) Choose the Correct Option from the four alternatives given (1 mark is for the correct

choice and 1 mark for justification/workings. You may present only the Roman numeral,

your choice and the reason/workings, without copying the question.) 2x10=20

(i) A company is considering four projects A, B, C and D with the following information:

Project A Project B Project C Project D

Expected NPV (`) 60,000 80,000 70,000 90,000

Standard deviation (`) 4,000 10,000 12,000 14,000

Which project will fit the requirement of low risk apetite?

(A) Project A

(B) Project B

(C) Project C

(D) Project D



(ii) From the following quotes of a bank, determine the rate at which Yen can be

purchased with Rupees.

`/£ Sterling 75.31 – 33

£ Sterling/Dollar ($) 1.563 – 65

Dollar ($)/Yen (¥) 1.048/52 [per 100 Yen]

(A) ` 124.02

(B) ` 142.02

(C) ` 412.02

(D) ` 214.02

(iii) The spot Value of Nifty is 4430. An investor bought a one month Nifty 4410 call option

for a premium of ` 12. The option is:

(A) In the money

(B) At the money

(C) Out of the money

(D) Insufficient data

(iv) A certain mutual fund has a return of 17% with standard deviation of 3.5% and the

sharpe ratio is 4. The risk free rate is

(A) 12.5%

(B) 4%

(C) 3%

(D) 7.5%

(v) The following information of a project are given below:

Expected cash flow (`) Probability

6,000 0.20

16,000 0.80

If certainty equivalent coefficient is 0.7, what will be certain (Risk less) cash flows of

the project?

(A) ` 12,000

(B) ` 9,800

(C) ` 9,000

(D) ` 15,400



(vi) The spot and 6 months forward rates of US dollar in relation to the rupee (`/$) are `

74.532/75.4143 and ` 75.1278/76.2538 respectively. What will be the annualized

forward margin (with respect to Ask price)?

(A) 2.42%

(B) 1.60%

(C) 2.23%

(D) 2.31%

(vii) B can earn a return of 18% by investing in equity shares on his own. Now he is

considering a recently announced equity based Mutual Fund Scheme in which

initial expenses are 1% and annual recurring expenses are 2%. How much should be

Mutual Fund earn to provide B, a return of 18%?

(A) 18.18%

(B) 20.18%

(C) 22.18%

(D) 21%

(viii) You are given the following information of a stock:

Strike Price ` 400

Current stock price ` 370

Risk free rate of interest 5%

Theoretical minimum price of a European 6 months’ put option after six months is

(A) ` 9.37

(B) ` 20.12

(C) ` 30.76

(D) ` 20.63

(ix) MS Ltd. is planning to invest in USA. The annual rates of inflation are 8% in India and

3% in USA. If spot rate is currently ` 75-50/$, what spot rate can the company expect

after 3 years?

(A) ` 65.49

(B) ` 79.16

(C) ` 87.04

(D) ` 72.00

If the covariance between the returns on a portfolio BC and returns on the market

index is 25 and the variance of returns on the market index is 20, what will be the

systematic risk of BC under the variance approach?



(A) 1.25

(B) 1.56

(C) 5.45

(D) 31.25

Answer:

(i) (A) Risk per unit of NPV = Std dev

x NPV

σ=

A = 4000

60000 = 0.066

B = 0.125

C = 0.17

D = 0.16

Hence A is chosen as least risky relative to NPV.

(ii) (A) Yen to be purchased with `

75.33 ` to purchase 1£

1.565 £ for 1 $

1.052 $ for 100 Yen

∴ `/100 Yen = 1.565 £ 1.052 $75.33

1£ 1$ 100 Yen× ×

= 124.02

(iii) (A) In an option, only the premium is paid up front, which is ` 12; ` 4,410 is the strike price

Current spot price = 4430 > 4410.

Hence it is in the money.

(iv) (C) P FR R

σ

−

= sharpe ratio, P FR R− = σ × sharpe ratio

∴ FR = PR σ− × sharpe ratio

= 17% – 3.5% × 4

= 17 – 14

= 3%



(v) (B) (Expected cash flow with risk) = [6,000 × .2 + 16,000 × .8]

∴ Certainty adjusted = [6,000 × .2 + 16,000 × .8] × .7

= 9,800

(vi) (C) Ask price diff = 76.2538 – 75.4143

= 0.8395

6 m margin = 0.8395

75.4143× 100%

Annualised = 0.8395

75.4143× 100% × 2 = 2.23%

(vii) (B) 18

99%+ 2% = 18.18 %+ 2% = 20.18%

[Initially, only 99% is available for investment]

(viii) (B) Spot price today = 370; Strike price = 400

= 400 × 6

5%12

e− ×

= 400 × ��.��

� = 400x .025e

−

= 400

1.02532

= 390.12

Put option value = 390.12 – 370

= 20.12

(ix) (C) 75.50 will become (75.50) (1.08)3 = 75.50 ×1.26

= 95.10

1 $ will become (1.03)3 = 1.09

∴ Expected rate = ��.��

�.�� = 87.08

(x) (D) Sys. risk = ��×�� ; � =

�

�= 1.25

= (1.25)2 × 20

= 31.25



Section-B

Answer any five questions.

2. KJ Hospital wants to install a testing equipment. It wants to analyse whether to purchase

the machine from a bank borrowing or to lease it from LR. The following information is

given:

(i) Cost of the equipment ` 50 lacs to be paid at the beginning of the 1st year

Life 5 years

(iii) Residual value ` 5 lacs at the end of the 5th year

(iv) Depreciation Cost less residual value, written off equally p.a. for

the life of the asset

Annual Lease Rent ` 12 lacs Payable at the end of each year from

year 1 to year 5

(vi) If asset is purchased, bank loan available at

10% interest per annum

Year-end payment includes `10 lacs each year towards principal and additionally, interest on the balance outstanding at the beginning of the year.

(vii) Annual maintenance charges to be incurred by KJ if the equipment is purchased

` 2 lacs per annum

payable at the end of each year

(viii) Tax rate applicable for KJ and LR

40% Assume KJ and LR are profitable

(ix) After-tax weighted average cost of capital

12% p.a. For both LR and KJ

(x) Long term capital gains tax 20% LR (For sale value in excess of the residual value)

The lessor LR is an investor company that specializes in the leasing of various medical

equipments across the country. LR would buy the equipment from its own funds, maintain

the machine incurring ` 1 lac p.a. (year end). LR is confident of reworking the equipment

at the end of 5 years at no extra cost and finding a rural hospital which would pay ` 13

lacs for it at the end of the 5th year. However, for its depreciation, it would write off equal

amounts each year considering (i) to (iv) as for KJ. The lessor is also a profit-making

company with a 40% corporate tax rate and 20% tax rate on long term capital gains.

(a) For KJ, present statements of discounted cash flows under the options of buying the

machine with borrowed funds and leasing, using the appropriate discount rate.

Present year wise annual cash flows (in ` lacs, up to two decimal places), without

netting off, arrive at the sub totals of pre-discounted cash flows for each year and

then apply PV factors (up to three decimals as given) and then arrive at the total

present value Use ‘+’ for inflows and ‘- or ( )’ for outflows.

(b) Evaluate the viability of the proposal for the lessor LR. Comment on the situation. 16



Answer:

2. (a) Outright Purchase option

End of

year Principal

Opening

Balance

Inter

est Main

tenance Deprecia

tion Total

Expenses

for tax

benefit

Tax

shield

40%

Cash

outflow

Prin+ Int

+ Maint

Cash

Flow

after

tax

shield

PV

factor

6%

PV of

cash

flows

0 50

1 40 5 2 9 16 6.4 17 10.6 0.943 -9.99

2 30 4 2 9 15 6 16 10 0.890 -8.90

3 20 3 2 9 14 5.6 15 9.4 0.840 -7.89

4 10 2 2 9 13 5.2 14 8.8 0.792 -6.96

5 0 1 2 9 12 4.8 13 8.2 0.747 -6.12

5 salvage value 5 0.747 +3.73

Total -36.13

Evaluation of leasing option:

End of year 1 2 3 4 5

Lease Rent 12 12 12 12 12

Tax savings 4.8 4.8 4.8 4.8 4.8

Net outflow (7.2) (7.2) (7.2) (7.2) (7.2)

Annuity factor (6%, 5 years) = 4.212

PV of lease outflows for KJ = 4.212 × (7.2) = (30.32)

Leasing is better.

(Lease vs. borrow should be evaluated at after tax cost of debt, i.e. 10% × (1-40%) = 6%)

(b)

From the Lessor’s view point, it is a capital budgeting problem and has to be evaluated at

after tax cost of capital, i.e. 12%

Cash outflow at the beginning of year 1 =` 50 lacs.

Salvage value = ` 13 lacs, WDV =` 5 lacs. Hence Long term capital gains = 8 × 20 % = `1.6 lacs.

Terminal Cash flows = 13 - 1.6 =` 11.40 lacs



Depreciation available = (50 - 5)/5 = ` 9 lacs. Tax shield per annum on depreciation =` 3.60

lacs.

Annual fixed lease rentals = ` 12 lacs. After tax LR = .6 × 12 = ` 7.2 lacs.

Annual Maintenance charges = 1 lac, after tax = ` 0.60 lac

(`)

End of year 0 1 2 3 4 5 5

Capital Cost -50

Lease Rent +7.2 +7.2 +7.2 +7.2 +7.2

Tax Shield on Depn +3.6 +3.6 +3.6 +3.6 +3.6

Maintenance - 0.6 - 0.6 - 0.6 - 0.6 - 0.6

Total Undiscounted

Cash flows -50 +10.20 +10.20 +10.20 +10.20 +10.20 +11.40

PV factor at 12% 1 3.605 0.567

PV of cash flows -50 +36.77 +6.46

Net -6.77

It is not viable for the lessor, LR.

For the lessor, this is an investment proposal of his business. Hence he has to evaluate it at the

weighted average cost of his capital, which is 12%.

Comment: For feasibility, the lessor has to increase the lease rents. But he cannot do so to give

a positive NPV since it will then be infeasible for the lessee, KJ. Then KJ will go for outright

purchase instead of lease. Hence, LR should only consider using borrowed funds, so that at

least he can take the marginal after tax cost of capital to justify this venture. However, in the

long run, it has to earn a positive NPV at the weighted average after tax cost of capital to

justify acceptability. He could work on decreasing the initial cost, since he may be buying

many such machines and therefore be eligible for substantial discounts. He could aim at a

better residual value. Most importantly, he should lower his cost of capital to be competitive.

3. (a) IP, an importer in India has imported a machine from USA for US $ 20,000 for which the

payment is due in three months. The following information is given:

Foreign Exchange Rates (`/US $) Money Market Rates (p.a.) (Compounded annually)

Bid Ask Deposit Borrowing

Spot 74.60 74.90 USS 6% 9%

3 months forward 75.50 75.90 Rupees 7% 11%



(i) Show with appropriate supporting calculations whether a money market hedge is

possible or not.

(ii) Compute the cost (in annualized percentage) of a Forward Contract Hedge.

(iii) Present rupee outflows under (i) and (ii) and advise the importer on the best

course of action to minimize rupee outflow.

(Exchange rate and values should be shown upto two decimal places) 8

(b) An investor had purchased a 4 month call option on the equity shares of N Ltd. of ` 10

of which the current market price is ` 132 and the exercise price is ` 150. You expect

the price to range between ` 120 to ` 190. The expected share price of N Ltd. and

related probability is given below:

Expected Price (`) 120 140 160 180 190

Probability 0.05 0.20 0.50 0.10 0.15

You are required to compute the following:

(i) Expected share price at the end of 4 months

(ii) Value of call option at the end of 4 months, if the expected price prevails.

(iii) In case the option is held to its maturity, what will be the expected value of the

call option? 8

Answer:

3. (a)

(i) After 3 months, the importer will purchase US$, i.e. it is a payable. For money market

hedge, he should create a US$ asset by borrowing `, investing in $ @ $ Deposit rate and

receiving $ at the end of three months.

= Spot Ask Rate (1+ borrowal rate for 3 months)(1+ $ deposit rate for 3 months)×

`

= 74.9

0.111 3

12

0.061 3

12

+ ×

× + ×

= 74.9 1.0275

1.015× = ` 75.82

This value 75.82 is less than the three months’ forward ask rate of ` 75.90. Hence money

market hedge is possible.

(ii) � ��.��

��×�

��.��

��×�

− 1�×100×12/3

Effective rate of money market hedge = 1.0275

1 4001.015

− × = 4.926%

Under forward contract hedge, effective rate annualized



= (Forward Ask Spot Ask) 12

100Spot Ask 3

−× ×

= 1 100 12

74.90 3

×× = 5.34%

(iii) Money market hedge:

Amount to be borrowed = 20,000

74.906%

1 312

× + ×

= 20,000

74.901.015

× = 19,704.43 $ ×74.90 `/$

= ` 14,75,861.81

Rupee needed today = 74.90 × 19704.43 = ` 14,75,861.81

Interest on this sum if borrowed today at 2.75% for 3 m (i.e. 11% pa) = ` 40586.20

Rupee outflow after 3 m = ` 15,16,448

Forward Contract Hedge:

Book a forward contract to purchase $ at 75.90 after 3 months.

Outflow after 3 m = 20,000 x 75.90 = ` 15,18,000

No initial outflow is required.

Equivalent outflow today = 15,18,000/1.0275 = ` 14,77,372.26

Money Market Forward Contract Difference

Today’s rupee outflow 14,75,861.81 14,77,372.26 1510.45

Rupee outflow after 3 m 15,16,448 15,18,000 1552

1510.45 today will become 1510.45 x 1.0275 = 1552 after 3 m.

Cash outflow under Money Market hedge is lowest, therefore it should be preferred.

3. (b)

Price Pi after 4 m

Probability Price x prob If held till maturity Call value Call value ×

probability

120 0.05 6 Call lapses 0 0

140 0.20 28 Call lapses 0 0

160 0.50 80 Call exercised +10 5



180 0.10 18 Call exercised +30 3

190 0.15 28.5 Call exercised +40 6

Total 160.50 14

(I) Expected share price after 4 months = ` 160.50

(ii) If price after 4 m = 160.50, value of call = 160.50 - 150 = 10.50. Since exercise price <

market price, call will be exercised.

(iii) Expected value of the option = ` 14

(iv) Expected pay off = Expected value of the option less option premium. Hence option

premium should be at the most ` 13 to make it worthwhile. At ` 14, pay-off is zero and

there is indifference,

4. (a) EC Limited is considering a new project with initial investment. It is estimated that IRR of

the project is 16% having an estimated life of 5 years. The Finance Manager has

studied that project with sensitivity analysis and informs that annual fixed cost sensitivity

is 7.8416%, whereas cost of capital (discount rate) sensitivity is 60%.

Other information available are:

Profit Volume Ratio (P/V) is 70%

Variable cost ` 60 per unit

Annual Cash Flow (year end) ` 57,500

Ignore depreciation on initial investment and taxes.

Calculate:

(i) Initial investment of the project

(ii) Net Present Value of the project

(iii) Annual Fixed Cost

(iv) Estimated annual sales units

(v) Break Even Units 8

(b) The expected returns on two stocks for particular market returns are given in the

following table:

Market Return Stock A Stock B

7% 4% 9%

25% 40% 18%

You are required to calculate:

(i) The beta of the two stocks.



(ii) The expected return of each stock, if the market return is 60% likely to be 7% and

40% likely to be 25%.

(iii) The security market line (SML), if risk free rate is 7.5% and market return is with

likelihood as per (ii).

(iv) The Alpha of the two stocks. 8

Answer:

4. (a)

(i) Initial Investment

At IRR of 16%, NPV = 0, Hence,

Initial Cost of Investment = PVIFA (16%, 5) × Cash Flow (Annual)

= 3.274 × ` 57,500

= ` 1,88,255

(ii) Net Present Value (NPV)

Let Cost of capital be x, then, (16-x)/x = 60%; x= 10%

Thus, NPV of the project = [Annual Cash Flow x PVIFA (10%, 5)] - Initial Investment

= (` 57,500 x 3.791) - ` 1,88,255

= ` 29,727.50

(iii) Annual Fixed Cost

Let change in the Fixed Cost which makes NPV zero is X. Then,

` 29,727.50 - 3.791 X = 0

Thus X = ` 7,841.60

Let original Fixed Cost be Y. Then,

Y x 7.8416% = ` 7,841.60

Y = ` 1,00,000

Thus, Fixed Cost = ` 1,00,000

(iv) Estimated Annual Units of sales

Selling Price per unit = ` 60/(100% - 70%) = ` 200

(Annual Cash Flow + Fixed Cost)/ P/V Ratio = Sales Value

(` 57,500 + ` 1,00,000)/0.70 = ` 2,25,000

Sales in Units = ` 2,25,000/ ` 200 = 1,125 units.

(v) Break Even Units

Fixed Cost/ Contribution per Unit = 1,00,000/140 = 714.285 units



Answer:

4.(b)

(i) Change in stock return = β (Change in market return)

A : (40-4) = β (25 – 7)

36

18β = = 2

B : (18 – 9) = β (25 – 7)

9

18β = = 0.5

(ii) Expected returns of the stock A: 60 % x 4 + 40 % x 40 = 2.4 + 16 = 18.40%

Stock B: 60 % x 9 + 40 % x 18 = 5.40 + 7.2 = 12.60%

(iii) Expected return of market = 60% x 7 + 40% x 25 = 4.2 + 10 = 14.20%

Security market line SML is the line drawn with betas on x axis and expected return on the

y axis and risk free rate = 7.5 % when x = 0, i.e. at zero beta.

Expected return based on SML = y = 7.5 % + β (14.20 % - 7.5%)

SML: y = 7.5% + β (6.7)%

(iv) For stock A, expected return y = 7.5 + 2 x 6.7 = 7.5+13.4 = 20.9

Average return = 18.40.

Alpha of A = – 20.9+18.4 = – 2.5%

For Stock B, expected return y = 7.5+0.5 x 6.7 = 7.5+3.35 = 10.85

Average return = 12.60.

Alpha of B = – 10.85 + 12.60 = 1.75%

5. (a) During a five year period, the relevant results for the aggregate market are that the

risk-free rate (rf) is 8% and the return on market (rm) is 14%. For that period, the results of

five portfolio managers are as follows:

Portfolio Manager Actual Average Return (%) Beta (/B)

A 13 0.80

B 14 1.05

C 17 1.25

D 13 0.90

E 15 0.95

Using CAPM model, you are required to



(i) calculate the expected rate of return for each portfolio manager and compare

the actual returns with the expected returns; and

(ii) find which of the mangers need to be warned for under-performance? 8

(b) A mutual fund made an issue of 20,00,000 units of ` 10 each at the beginning of the

year. No entry load was charged. It made the following investments:

Particulars Amount (`)

1,00,000 Equity shares of ` 100 each @ ` 160 1,60,00,000

8% Government Securities 16,00,000

11% Debentures (unlisted) 10,00,000

10% Debentures (listed) 10,00,000

Total 1,96,00,000

During the year, dividends of ` 24,00,000 were received on equity shares. Interest on all

securities was received for a full year as on the valuation date. Equity shares have a

value of ` 180 per share as on valuation date and unlisted debentures are to be valued

at 85% of the invested value. Initial expenses were ` 3 lacs, which are fully charged to

the scheme in the first year. Up to the end of the year, operational expenses incurred

were ` 4 lacs, of which ` 1.5 lacs remains payble next year. Just before the year end,

60,000 units were redeemed when the NAV was ` 12.5 NAV per unit and an exit load of

1 % was charged. Find the NAV per unit as on valuation date which is at the end of the

year. 8

Answer:

5. (a)

(i) CAPM Equation:

R, = Rf + β (Rm - Rf)

Where Rj = Expected rate of return

Rf = Risk free rate

Rm = Return on Market

β = Beta

The expected rates of return are as follows:

Portfolio

Manager Expected Return (%) Actual Average

Return (%) Difference between Actual

& Expected Returns

A 8% + 0.80 (14%-8%) = 12.8 13 + 0.2

B 8% + 1.05(14%-8%)= 14.3 14 - 0.3

C 8% + 1.25(14%-8%)= 15.5 17 +1.5



D 8% + 0.90(14%-8%)= 13.4 13 - 0.4

E 8% + 0.95(14%-8%)= 13.7 15 +1.3

(ii) Managers B and D did not perform upto expectation ,they have to be warned.

(b) (`)

Investments made as per question 196,00,000

Initial Expenses 3,00,000

Cash balance (initial) 1,00,000

Amount collected = 20 lakh units × ` 10 /u. 200,00,000

Value of Investments at valuation date (`) Income(`)

Equity share 1,80,00,000 24,00,000

8% Govt. securities 16,00,000 1,28,000

11% Debenture (Unlisted) 8,50,000 1,10,000

10% Debenture (Listed) 10,00,000 1,00,000

214,50,000 (A) 27,38,000

Less : Redemption ` 12.5 × 60,000U (7,50,000)

Add : Exit load 1% 7,500

Less : Expenses paid (2,50,000)

Add : Cash 1,00,000

(B) 18,45,000

Total : Assets (A) + (B) 232,95,500

Less : Expenses payable (1,50,0000)

Net Assets ` 231,45,500

Units = 20,00,000 – 60,000 = ` 19,40,000

NAV per unit = 231,45,500

19,40,000 = ` 11.93

6. (a) An investor has the following constituent holdings in his portfolio:

Security No. of shares Price per share (`) Share Beta

A 400 500 1.4

B 500 750 1.2

C 200 250 1.6



(i) Find the market value weighted average beta of his portfolio.

(ii) If the investor wants a target beta for his portfolio at 0.9, how would he dispose of his

securities and replace them with Government securities if he want to sell in the

order of risk? Present the revised tabulation of his holding and prove that the target

beta has been achieved by your advice.

(iii) If he is willing to invest further, how much investment should he make in G Sec

to make his beta 0.9, without selling any share at all? 10

(b) An 8.5% bond of `1,000 face value with five year maturity at par and a yield to maturity

of 10% has `954.74 as the current market value. Calculate the price of the bond and

compare it with the market price. What action should the holder of the bond take? 6

Answer:

6. (a)

(i)

Security Nos Price(`) Value(`) Beta Weight Weight x Beta

A 400 500 2,00,000 1.4 0.32 0.448

B 500 750 3,75,000 1.2 0.6 0.72

C 200 250 50,000 1.6 0.08 0.128

Total 1100 625000 1.296

Portfolio’s beta based on market value weights is = 1.296

(ii) Target beta = 0.9.

We should first replace the riskiest of the securities with Govt. zero beta securities. Then

we go for the next riskier one. Hence, C, being of lower market value should be fully

replaced by Govt. securities.

If we assume full of A to be sold, then, b x 1.2 = .9 × 625000 = ` 562500. Then, solving, we

get b = 468750 which is more than ` 3,75,000 . This means that any of B should not be

sold and that A too should not be sold in full.

Hence, 375000 × 1.2 + a × 1.4 = 625000 × 0.9

450000 + 1.4 a = 562500

Or, a = 112500/1.4 = ` 80357.

` 80357 value of A should be retained in the portfolio. This amounts to 80357/500

= `160.714 shares, which is 161 shares.



Hence the new portfolio will consist of 161 shares of A, 500 shares of B and no share of

C and Govt., securities worth ` 169500 (50,000 from C and 200000 – 80500 = ` 119500

from A)

Proof:

Security Nos Price

(`)

Value

(`)

Beta Weight Weight x Beta

A 161 500 80,500 1,4 0.1288 = 80500/625000 0.18032

B 500 750 3,75,000 1.2 0.6 = 375000/625000 0.72

C 0 250 0 1.6 0

Govt. Securities 169500 0 0

Total 625000 0.90032

Thus the new portfolio beta will be the targeted 0.9

(iii) Without selling any share, if investment has to be made, say for value ‘g’ in govt,

security, weighted beta

= (6,25,000 1.296) (g 0)

(6,25,000 g)× + ×

+= 0.9

= 6,25,000 (1.296 – 0.90) = 0.90 g

g = 625000 0.396

0.90

× = ` 2,75,000 market value worth G Sec should be purchased.

6. (b)

Year PV factor 10% Cash Flow(`) PV at 10% (`)

1 0.909 85 77.27

2 0.826 85 70.21

3 0.751 85 63.84

4 0.683 85 58.06

5 0.621 85 52.79

5 0.621 1000 621.00

Total 943.17

The bond is overpriced since the present value at 10% is only ` 943.17 whereas the

market price is ` 954.74. Hence it should be sold.



7. (a) Companies X and Y want to raise US$ 50 million each. They have been offered the

following rates per annum:

Company Fixed Floating

X 7.5 LIBOR + 25 bps

Y 8.45 LIBOR + 37 bps

Bank B, on a commission of 0.2% (fully borne by Y) is arranging an interest rate swap

between X and Y. X wants a floating rate and Y wants a fixed rate. Work out the

payables and receivables on the swap (in %), given that the benefits (after

commission) are shared between X and Y in the ratio 60 : 40. What will be the effective

rate of interest payable by X and Y their respective gains (in %) due to the swap? How

many dollars does each save per annum due to the swap? 8

(b) The US $ is selling in India ` 75.90. The interest rate for a 6 months borrowing in India is

10% per annum and the corresponding rate in US is 4%.

(i) Do you expect that US$ will be at a premium or at a discount in the Indian Forex

Market? Why?

(ii) What will be the expected 6-months forward rate for US $ in India?

(iii) What will be the annualised rate of forward premium or discount? 8

Answer:

7. (a)

Company Fixed Floating

X 7.5 LIBOR + 25 bps

Y 8.45 LIBOR + 37 bps.

Differential 0.95 0.12

Net difference 0.95-0.12 = 0.83

Bank’s Commission 0.20

Balance Gain 0.83 – 0.20 = 0.63 60% x 0.63 = 0.378 40% × 0.63 = 0.252

X Y

Borrow At fixed rate 7.5% At floating rate LIBOR + 0.37%

Pay bank (7.5%) (LIBOR+ 0.37%)

Collect differential from Y 7.5% - (LIBOR+ 0.25%)

+ 7.25 % - LIBOR (7.25-LIBOR)

Pay Bank’s Commission (0.2)

Receive gain from Y +0.378 (0.378)

Net interest = Effective rate of interest

- 0.25-LIBOR + 0.378 = (LIBOR -0.128)

(7.25+0.37+0.2+0.378) = 8.198

Original Interest LIBOR+ 0.25 8.45



Gain p.a. due to the swap 0.378 0.252

Gain in dollars p.a. 0.378% x 50 m = $ 1,89,000

0.252 x 50 m = $1,26,000

(b)

(i) The US $ is expected to quote at a premium in India as the interest rate is higher in

India.

(ii) Calculation of Forward Rate:

F11 Rh

1 Rf E 0

+=

+

Rh is home currency interest rate, Rf is foreign currency interest rate, F1 is end of the

period forward rate and Eo is the spot rate.

1 ( 0.10 / 2) F11 ( 0.04 / 2) 75.9+

=+

or 1 0.05 F1

1 0.02 75.9

+=

+

or 1. 05 F1

1.02 75.9=

or 79. 70

F11.02

=

or F1 = ` 78.14

(iii) Rate of Premium

78.14 75.9 12100

75.9 6

−× × = 5.90% or 2.95% for 6 months.

8. Answer any four out of the following five questions:

(a) State the differences between Commercial Papre (CP) and Certificate of Deposit (CD)

on the following aspects: 4

(i) Issuer

(ii) Conditions to be satisfied by an issuer to be eligible for an issue.

(b) State the differences between Indian Treasury Bills and Central Government securities

on the following aspects: 4

(i) Purpose of issue

(ii) Tenor



(c) Name the most appropriate combined trading strategy on the stock of PQ Ltd. in the

following independent cases. (You may present only columns I and II in your answer

books.) 4

SI. No. Strategy Action Expiry Date Strike Price

Buy Sell

I II HI IV V VI

(i) One call

One put 30th June

30th June 215

215

(ii) Two Calls One Put

20th June 20th June

220 220

(iii) One Call Two Puts

20th June 20th June

230 230

(iv) One call One Put

20th June 20th June

215 220

(d) State the differences between the commodity market and equity market futures in the

following aspects: 4

(i) Initial Margin

(ii) Basis of price movements

(e) How would you choose indivisible projects under capital rationing? Can there be a

situation where a project with lower NPV is chosen while discarding a project with

higher NPV? Explain. 4

PV Factor Table:

Annuity Factors

End of Year

Rate 1 2 3 4 5 4 yrs 5 yrs

4% 0.962 0.925 0.890 0.855 0.822 3.632 4.454

4.8% 0.954 0.910 0.869 0.829 0.791 3.562 4.353

6% 0.943 0.890 0.840 0.792 0.747 3.465 4.212

7.2% 0.933 0.870 0.812 0.757 0.706 3.372 4.078

8.5% 0.922 0.849 0.783 0.722 0.665 3.276 3.941

10% 0.909 0.826 0.751 0.683 0.621 3.169 3.791

12% 0.893 0.797 0.712 0.636 0.567 3.038 3.605



e-0225 1.0228 e-0.0225 0.978

e0.025 1.02532 e-0.25 0.975

e0-225 1.2523 e-0.225 0.799

e0.25 1.2840 e-0.025 0.779

e0.5 1.6458 e-05 0.608

Annuity factors for 5 years:

Rate 8% 9% 10% 11% 12% 13% 14% 15% 16% 17% 18%

Factor 3.993 3.890 3.791 3.696 3.605 3.517 3.433 3.352 3.274 3.199 3.127

Answer:

8 (a)

CP CD

Issuer Corporates, Primary Dealers Scheduled Commercial Banks other

than RRBs, Local Area Banks

Eligibility Tangible net worth not less than `4 cr.

Working capital limit not to be less

than ` 4 cr.

Credit rating to be at least P-2 of

CRISL or PP2/ P2 of D2 of other rating

agencies

Banks have to maintain CLR and SLR

on the issue price of CDs

(b)

T Bill G Sec

Purpose To tide over short term liquidity

shortfalls To meet Govt, expenditure

commitments

Tenor 91 days, 182 days, 364 days. More than 1 year, up to 30 years.

(c)

Sl. No. Strategy

I II

(i) Straddle or



Long Straddle

(ii) Strap

(iii) Strip

(iv) Strangle

(d)

Futures Commodity Market Equity Market

Initial Margin Lower in the range of 4-5-6% Higher in the range of 25-40%

Basis of Price Movements Purely based on Demand and supply of commodities

Based on expectation of future performance

(e)

Capital Rationing: This refers to prioritizing the projects based on NPV. The available

capital is limited and therefore all projects with positive NPV cannot be selected. Hence,

projects are arranged in the order of NPV (descending order) and the cumulative project

cost is tabulated. When available capital is exhausted, the process of selection has to

stop. But in the case of indivisible project, i.e. part project cannot be undertaken and

therefore, we may have unutilized capital. Therefore, we may leave out the last one and

choose the combination which maximizes the NPV. While doing so, we may have a

situation where the project with better NPV is not selected since its selection would involve

under utilization of capital. For example, consider the following table:

Project Capital Outlay NPV (` lacs) Cumulative outlay

A 200 +250 200

B 225 +200 425

C 400 +180 825

D 175 +100 600

Suppose that available capital is ` 600 lacs. If we stop with B, since funds will be insufficient

for C, we are not utilizing ` 175 lacs of capital. Hence, We can go for D, which has lesser

NPV. The project is indivisible. Hence we cannot go for part of C which yields proportional

NPV.

Documents

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